Wealth Insights

The first estimate for Q1 2019 GDP was considerably better than expected, with the economy expanding at a 3.2% annual pace versus consensus expectations for 2.3% and growth of 2.2% in Q4 2018.

There were components that contributed to Q1 GDP that helped growth but are not expected to repeat with such magnitude. Net exports plus a build-up in inventories contributed 1.68% to GDP. That's the biggest combined contribution by these two components in six years.

The last three consecutive quarters have seen private inventories accumulate as firms stock-piled in preparation of a possible escalation in trade tariffs. The buildup in inventories, which contributed 0.65% to GDP, has likely pulled forward growth from upcoming quarters.

Net exports added 1.03% to overall GDP growth, as exports increased 3.7% annualized and imports contracted by 3.7%. The positive contribution from exports is likely to moderate throughout the remainder of 2019 in the face of ongoing weakness in global growth. Furthermore, demand for imports is expected to improve as consumer spending gains traction after a slow start to the year. The mix of slowing exports and rising imports will lower the potential contribution of net exports to total GDP.

A third component that is unlikely to support output by the degree seen in Q1 is government spending. Despite the federal government shutdown, spending by government agencies contributed 0.41% to GDP, driven primarily by 0.35% at the state and local level. This was mainly due to a temporary jump in spending on highways and roads. Given the condition of most government budgets, this is not expected to be sustainable in future quarters.

Consumer spending, the largest segment of economy, rose at a modest-to-moderate 1.2% pace and contributed 0.82% to the quarter. The increase in consumer spending reflected an increase in services (led by health care) that was partly offset by a decrease in goods, specifically motor vehicles and parts. Business investment, a measure of corporate confidence in the economy, rose at a moderate 2.7% pace and added 0.38% to the quarter. Investment by companies was almost entirely due to a big gain in intellectual property products (software and research), while spending on structures and equipment was noticeably absent.

A clearer look at underlying domestic demand is seen from final sales to domestic purchasers, a reading that excludes both net exports and inventories. The growth rate from final domestic sales was only 1.4%. Lack of consumer spending in Q1 was a significant reason and is a bit of a mystery given the strength of the U.S. labor market. Payroll employment rebounded to 196,000 in March after a subdued 33,000 gain in February, while preceded by a sharp 312,000 gain in January. With the slump in the stock market now fully reversed, credit spreads narrowing and the yield curve steepening again, consumption and investment growth are poised to improve in the second quarter.

Another positive for Q2 is that the risks of a trade war with China have significantly diminished. Furthermore, China has taken vigorous efforts to re-stimulate its economy through monetary easing, tax cuts and more infrastructure spending. The efforts appear to be paying off. This has lifted trade and revitalized China’s supply chains throughout Asia. In addition, the British decision to delay a verdict on Brexit has allayed fears of what would have been a debilitating no-deal Brexit - at least until the new deadline at the end of October. As a result, business confidence in the region has at least stabilized.

Finally, the U.S. economy has also received a lift from the Federal Reserve’s hard pivot away from interest rate hikes. The Fed increased the federal funds rate four times last year, a quarter percentage point each time, and as recently as late last year was on track to raise rates several more times this year and early next. Now, no rate hikes are expected this year and few, if any, next year. This has the potential to give a boost to rate-sensitive sectors of the economy, including housing. Meanwhile, the drop back in core PCE inflation, to just 1.7% in the first quarter is another reason for the Fed to maintain its neutral policy stance this year.

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Donald has a Doctorate of Philosophy in economics and has accumulated over 25 years of experience in investment management. As Senior Economist, Don analyzes factors driving the economy and interprets their effect on the investment markets. He provides advice and consultation on economic relationships to clients and to the firm's equity and fixed income investment teams. He is frequently sought out for his expertise in portfolio modeling and macro-economic analysis.

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